Thursday, May 24, 2007

Arbitrage Opportunity?

A blog reader identifies a strange pattern over at Tradesports:

For the 2008 elections, tradesports has approximately a 40% chance of Hillary being President and a 50% chance of her being the democratic nominee. With the Democrats having about a 57% chance of winning the election and with Obama and Gore having above 50% chances of winning, the 80% (40/50) that Hillary has looks awfully suspect and I assume someone is manipulating the 40% number to make Hillary look better. With the efficient market hypothesis in mind, is this at all possible or is an arbitrage opportunity available?

The numbers look odd to me as well. Here is an apparent arbitrage:

Sell Clinton (bid is now 38.3), Obama (16.5), Gore (7.3), and Edwards (3.6) for a total of 65.7. Buy a contract for a generic Democratic win (ask is now 56.8). You pocket the difference (65.7-56.8=8.9). You have to pay out on the first contract if one of these four candidates wins, but in that case you are covered by the second contract. The only contingency in which you lose is if Clinton, Obama, Gore, or Edwards end up president as an independent or Republican candidate, which seems completely unlikely.

So why am I giving away this arbitrage opportunity for free? I must be either unsure of my analysis, or motivated by the search for truth rather than money. Your call.

About Me

I am the Robert M. Beren Professor of Economics at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.